Borrowing Startup Money from Family Members

Starting up with just the next big idea is just that: an idea. In reality, new businesses need money, usually more than that amount initially calculated alongside that very first draft of the business plan. And sometimes, those funds can come from family.

However, borrowing capital from family members is risky business. Sure, you can always cut bonds with an external investor when a deal goes sour, but you can’t exactly burn bridges with relatives, especially just before seeing them at family gatherings. Even more so, these well-meaning lenders don’t always know what they’re getting into — and what they may not be getting out it in the end.

We asked members of the Young Entrepreneur Council (YEC), an invitation-only nonprofit organization comprised of the country’s most promising young entrepreneurs, the following question to find out their advice for funding through family ties:

“What’s one piece of advice for entrepreneurs who want to raise money from family without ruining relationships?”

Here’s what YEC community members had to say:

1. Be Transparent ‘Til It Hurts

“It’s tempting to paint an eternally rosy picture for investors, but the reality of any startup is that there are difficult times. All of our first investors were friends and family, and we’ve managed to maintain strong, positive relationships by being completely honest — for better or worse. Transparency honors the risk early investors took and allows space for them to provide advice or help.” ~ Martina Welke, Zealyst

2. Remember, It IS Personal

“It is easy to think that if we are upfront about the terms, transparent in our discussion, and even fair in our valuation that this will “just be business.” Unfortunately, it rarely is in the case of raising money from family. Chances are, there is going to be some type of emotion involved and it is going to be personal at some level.” ~ W. Michael Hsu, DeepSky

3. Stay Professional

“Structure it like any other investment, and try to separate your professional self from your family self. Draw up contracts, act professional, and send formal “investor” updates each month.” ~ Abby Ross, Blueye Creative

4. Manage Expectations

“Always manage expectations when it comes to borrowing money from family. At the time you “pitch” your family to be investors, don’t over promise on potential returns. By being transparent and continuing to keep them in the loop after they invest, you give them a sense of connection to the business — and less resentment if things go bad.” ~ Blake Beshore, Tatroux

5. Explain the Real Risks

“Family needs to understand that they should only invest money that they are willing to lose. If they have disposable cash, then it will not be a large financial hardship if the money is lost. If family members can’t afford to lose money, they shouldn’t invest. It’s the entrepreneur’s job to be upfront and cl ear about this.” ~ David Ehrenberg, Early Growth Financial Services

6. Do They Like to See Money Burn?

“The default state for a startup is death (http://paulgraham.com/hubs.html), according to Y Combinator founder Paul Graham. So be honest with your family. Ask them if they would be okay lighting their money on fire. If they can live with it, then let them invest. If not, then a relationship has been saved.” ~ Wade Foster, Zapier

7. Treat Them Like Real VCs

“Pitch them as they were a high-level VC by bringing real presentation tools, a thorough business plan and facts to the table. Don’t skip on these important aspects to eliminate any bad feelings of abuse or problems down the road.” ~ Raul Pla, SimpleWifi and UseABoat

8. Represent All Outcomes

“Prepare them for the worst. Let your family know that there’s a high likelihood that they’ll lose their money, and that they should think of the investment as a gift. Most startups fail. If they aren’t willing to invest under those terms, then don’t take their money. Avoid overselling them so they don’t feel duped later.” ~ Bhavin Parikh, Magoosh Test Prep

9. It’s Strictly Business

“Taking money from friends and family can be tricky. It’s important to treat the deal with the professionalism as you would when dealing with a VC. Be transparent and make sure your friend or family member has done the proper due diligence, read all the documents and is investing because he or she believes in not only you, but also your business.” ~ Kevin Tighe II, The Brand Stars

10. Maintain Communication

“Families are a tricky bunch. Having worked with mine for the past 5 years, I’ve learned some of the nuances necessary to keep relationships healthy. Make sure you designate one person as your point of contact and by all means communicate with them. Even if it feels like court reporting, they appreciate being kept in the loop. It can feel like an extra job, but it is. You wanted family money.” ~ David Cohen, Round Table Companies

11. Sell Your Idea

“Ideally your supporters are investing in your idea and not just in you. Tell your family and friends your idea and if they are interested and able, they will want to invest. If you know a donor is investing solely for personal reasons, accept the donation with no strings attached, but know where you stand with them and replace them with donors that care about your idea.” ~ Melissa Kushner, Goods For Good

12. Smaller Amounts Are Key

“Don’t talk Grandma into investing her entire pension. Just make sure your family members invest a comfortable amount, in case things go sour. It’s better to have more people put in small amounts than to share your parents’ basement with Grandma after you both go bankrupt.” ~ Nicolas Gremion, Foboko.com

The Young Entrepreneur Council (YEC) is an invite-only organization comprised of the world's most promising young entrepreneurs. In partnership with Citi, YEC recently launched StartupCollective, a free virtual mentorship program that helps millions of entrepreneurs start and grow businesses.

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Don’t forget to have them charge interest. There’s a nominal interest rate calculated by the IRS which, if charged, will prevent tax issues from arising due to imputed interest.

Another way to approach is to have them gift the money to you. That way, there is no expectation of return of or return on capital. It’s a gift. Rich relatives may want to consider gifting strategies in 2012 vs. 2013 due to tax law changes.

Finally, document everything. Whether it’s a gift or a loan, make sure that there are appropriate documents between both parties so that there can be no room for misinterpretation later.

If you’re going to take a loan from a family member (I don’t recommend it) then these are great points to avoid a bad outcome. However, I would say that if the family member isn’t 100% comfortable never getting the money back, they shouldn’t loan it.

Borrowing money from a family member is the same as borrowing money from a bank and the person deserves to be treated in the same manner. Know BEFORE you enter into an agreement that you WILL pay them back no matter what. Promise yourself, not them.

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